Compensation and Remuneration of Directors

Introduction

Director compensation and remuneration play a critical role in corporate governance, ensuring that directors are fairly compensated for their services while maintaining transparency, accountability, and regulatory compliance. The Companies Act, 2013, along with SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, governs the remuneration of directors in India. Various provisions ensure that director remuneration aligns with company performance, stakeholder interests, and legal standards.
Director remuneration includes salaries, sitting fees, performance-based incentives, profit-linked bonuses, stock options, and other perquisites. Ensuring fair and just remuneration is essential to attract and retain competent directors while preventing excessive compensation that could harm shareholder value.

Legal Framework Governing Directors’ Remuneration

The remuneration of directors in India is governed by various legal provisions to ensure transparency, accountability, and fairness in compensation. The Companies Act, 2013, along with regulations by the Securities and Exchange Board of India (SEBI), establishes the framework for determining and disclosing directors’ remuneration.
1. Companies Act, 2013
o Section 197 prescribes limits on remuneration for executive and non-executive directors, capping total managerial remuneration at 11% of net profits unless special approval is obtained.
o Section 198 lays down the method for computing net profits for remuneration purposes.
o Section 149(9) states that independent directors cannot receive stock options but may be paid sitting fees and profit-based commissions.
2. SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015
o Requires listed companies to disclose directors’ remuneration in annual corporate governance reports.
3. Schedule V of the Companies Act, 2013
o Governs remuneration in case of inadequate profits, imposing limits unless shareholder or government approval is obtained.
4. Income Tax Act, 1961
o Classifies directors’ remuneration for tax purposes, applying TDS (Tax Deducted at Source) under Sections 192 and 194J, depending on the nature of compensation.

Categories of Director Remuneration

Director remuneration varies depending on their role, responsibilities, and level of involvement in the company. The Companies Act, 2013, and other regulations govern the compensation structure to ensure fairness and compliance with corporate governance norms.

Executive Directors’ Remuneration

Executive directors, including Managing Directors (MDs) and Whole-Time Directors (WTDs), are actively involved in a company’s daily operations. Their remuneration consists of fixed and variable components, such as salary, performance incentives, and stock options.
Key Legal Provisions:
● Section 197 of the Companies Act, 2013:
o Limits total managerial remuneration to 11% of net profits, with specific caps for executive directors unless shareholder approval is obtained.
o Individual executive directors cannot receive more than 5% of net profits, and multiple executive directors cannot collectively receive more than 10% of net profits unless approved by shareholders.
● Section 198 outlines the computation of net profits to determine remuneration.
● Schedule V provides for remuneration in case of inadequate profits, requiring special approvals for exceeding prescribed limits.
● SEBI’s Listing Regulations, 2015, mandate disclosures of executive remuneration in corporate governance reports.
Non-Executive Directors’ Remuneration
Non-executive directors (NEDs) do not engage in daily management but provide strategic oversight and governance. Their remuneration is typically lower than executive directors.
Remuneration Components:
● Sitting fees: As per Section 197(5), NEDs receive sitting fees for attending board and committee meetings, subject to prescribed limits.
● Profit-related commission: Requires shareholder approval but is permitted under corporate governance norms.
● Reimbursement of expenses: Travel and other costs incurred while performing directorial duties are reimbursed.

Independent Directors’ Remuneration

Independent directors are non-executive directors with no financial or managerial interest in the company, ensuring corporate governance, transparency, and accountability.
Key Legal Provisions:
● Section 149(9): Independent directors cannot receive stock options but are entitled to sitting fees and profit-based commissions.
● Schedule IV: Prescribes guidelines for independent directors’ remuneration, ensuring it is linked to their responsibilities and market standards.
Remuneration of Nominee Directors
Nominee directors are appointed by financial institutions, investors, or the government to represent their interests in a company.
Remuneration Structure:
● Compensation is based on agreements with the appointing entity rather than standard company policies.
● They may receive sitting fees, reimbursements, and fixed honorariums, but profit-based commissions are generally not applicable.

Regulatory Limits on Directors’ Remuneration

The Companies Act, 2013, imposes limits on directors’ remuneration to prevent excessive payouts and ensure financial prudence. These limits apply to executive and non-executive directors, particularly in cases of profit fluctuations.
Maximum Limits on Remuneration (Section 197)
● Overall Cap: The total managerial remuneration (including all directors) must not exceed 11% of the company’s net profits, as calculated under Section 198.
● Limits for Executive Directors: Managing Director (MD) or Whole-Time Director (WTD) – An individual director can receive up to 5% of net profits. If more than one MD/WTD exists – The combined remuneration cannot exceed 10% of net profits.
● Limits for Other Directors: If the company has an MD/WTD – Other directors collectively can receive up to 1% of net profits. If no MD/WTD exists – The limit increases to 3% of net profits.
Remuneration in Case of Inadequate Profits (Schedule V)
● If the company does not have sufficient profits, directors’ remuneration is capped based on Schedule V of the Companies Act, 2013.
● Higher remuneration beyond these limits requires special approval from shareholders and, in some cases, the Central Government.

Determining Directors’ Compensation

The remuneration of directors is a critical aspect of corporate governance, ensuring fairness, transparency, and alignment with company performance. The process is regulated under the Companies Act, 2013, and overseen by the Nomination and Remuneration Committee (NRC).
Role of the Nomination and Remuneration Committee (Section 178)
● Requirement for Listed Companies: Listed companies must establish an NRC to formulate policies on directors’ compensation.
● Objectives of the NRC: Ensure that directors’ remuneration is fair, transparent, and performance-linked. Align compensation with industry standards and shareholder interests. Evaluate directors’ qualifications, responsibilities, and company performance before deciding remuneration.

Factors Considered in Fixing Remuneration
1. Company Performance and Profitability: Directors’ pay is often linked to financial performance metrics such as revenue, profits, and shareholder returns.
2. Director’s Experience, Qualifications, and Industry Standards: Compensation varies based on expertise, role, and responsibilities within the company.
3. Market Trends in Executive Compensation: Industry benchmarks and global pay trends influence remuneration decisions.
4. Shareholder Interests and Corporate Governance Principles: Ensures directors’ pay is justified and aligned with long-term corporate objectives.

Disclosure and Approval Requirements
Ensuring transparency and regulatory compliance in directors’ remuneration is essential for corporate governance. The Companies Act, 2013, along with SEBI (LODR) Regulations, 2015, mandates disclosure and approval processes to prevent excessive or unfair compensation.
Board and Shareholder Approval
● Board Approval: Directors’ remuneration must be approved by the Board of Directors, ensuring it aligns with company performance and governance principles.
● Shareholder Approval: Special Resolution is required in a general meeting if remuneration exceeds statutory limits under Section 197 of the Companies Act. Shareholders’ approval is also necessary when paying remuneration in cases of inadequate profits under Schedule V.
Disclosures in Financial Statements (Section 134 & 197(12))
● Annual Report Disclosures: Listed companies must disclose detailed remuneration of directors in financial statements.
● Ratio of Pay Disclosure: Companies must disclose the ratio of executive director remuneration to median employee pay, ensuring fairness and transparency.
SEBI (LODR) Regulations on Disclosure
● Corporate Governance Reports: Listed companies must publish director remuneration details in their annual corporate governance reports.
● Independent Directors’ Compensation: The remuneration of independent directors must be disclosed separately from executive directors to maintain transparency and prevent conflicts of interest.

Taxation of Directors’ Remuneration

● Salary-based remuneration (for executive directors) is taxed under Income Tax Act, 1961 as “Salary Income”.
● Sitting fees and commission (for non-executive directors) are taxed as “Income from Other Sources”.
● Companies must deduct TDS under Section 192 or Section 194J, depending on the nature of payment.

Case Laws on Directors’ Remuneration

NCLT’s Ruling in Tata Sons v. Cyrus Mistry (2021)
Facts: Cyrus Mistry, former Chairman of Tata Sons, challenged his removal, alleging governance lapses and arbitrary board decisions, including executive remuneration policies.
Held: The National Company Law Tribunal (NCLT) ruled that:
o The Board of Directors has the authority to decide executive compensation, but decisions must align with corporate governance norms.
o Executive remuneration should be linked to performance and follow a transparent approval process.
Significance: The case reinforced that director pay must be justified, reasonable, and subject to shareholder and board oversight.

LIC v. Escorts Ltd. (1986)

Facts: LIC, a major shareholder in Escorts Ltd., challenged certain remuneration decisions of directors, arguing they were against shareholder interests.
Held: The Supreme Court ruled that:
o Directors must act in good faith when determining remuneration.
o Shareholders have the right to scrutinize and approve directors’ compensation, especially in listed companies.
Significance: This case reinforced the principle that shareholder rights must be respected in approving remuneration packages.

R.K. Dalmia v. Delhi Administration (1976 AIR 915)

Facts: R.K. Dalmia, a company director, was accused of misusing corporate funds and drawing excessive, unjustified remuneration.
Held: The Supreme Court ruled that:
o Excessive director remuneration constitutes a breach of fiduciary duty and can attract legal action.
o Directors must ensure their compensation is reasonable, justified, and in compliance with statutory provisions.
Significance: This ruling emphasized corporate accountability, preventing directors from exploiting their positions for personal financial gain.

Non-Compliance and Legal Consequences of Directors’ Remuneration

Failure to comply with statutory provisions governing directors’ remuneration can lead to financial penalties, regulatory action, shareholder lawsuits, and even criminal liability. The Companies Act, 2013, and SEBI regulations impose strict guidelines to prevent misuse of corporate funds for excessive or undisclosed director compensation.
1. Penalty under Section 197(15) – Refund of Excess Remuneration
If a company pays remuneration beyond prescribed limits under Section 197 without proper approval, the directors must refund the excess amount. Non-compliance may attract penalties, including fines imposed on both the company and the directors.
2. Shareholder Lawsuits – Protection of Minority Interests
Minority shareholders can challenge unfair director remuneration under corporate governance laws. Courts have upheld that arbitrary or excessive payments violate fiduciary duties, as seen in R.K. Dalmia v. Delhi Administration (1976).
3. Regulatory Actions – SEBI and MCA Oversight
The Securities and Exchange Board of India (SEBI) and the Ministry of Corporate Affairs (MCA) can penalize listed companies for non-disclosure or misrepresentation of director remuneration. SEBI’s Listing Obligations and Disclosure Requirements (LODR) mandate proper disclosures in annual reports.
4.Criminal Liability – Fraudulent Transactions (Section 447)
If a director receives fraudulent payments, they can be prosecuted under Section 447 of the Companies Act, facing imprisonment up to 10 years and heavy fines. This provision ensures that directors do not misuse their position for personal gain.

Reference

Taxmann’s Company Law and Practice